Options In Trading Ranges by David L. Caplan
Options have a natural appeal due to the limited risk aspect for the options buyer, but there is a tradeoff: Because of the time decay factor, options lose value. However, as David Caplan, publisher of the Opportunities in Options newsletter, points out, you can take advantage of the time value decay characteristics. Here's how.
Option purchases and futures trades are only successful if the market moves in the direction predicted
(without the trader being stopped out first, naturally). In addition, option buyers have to worry about time
value decay of their position. Time value decay is a problem because the price of an option is made up of
two components, the time value and the intrinsic value. The intrinsic value is simply the difference
between the strike price and the current price of the underlying instrument. If the option is out of the
money, then the intrinsic value is zero. If you purchase an option, then the underlying instrument must
move in a price direction that will offset the time value decay.
But there is a position that a trader can successfully take in the options market in a nontrending or choppy
market or if the market moves lower or higher slowly. The option position is known as writing a strangle,
in which a call and a put are sold with strike prices out of the money. We are selling an out-of-the-money
put and call containing only time value, with the expectation of collecting the time value premium as the
underlying futures contract remains within a wide trading range. The time value premium decays every
day for both puts and calls, and this decay accelerates as the options approach expiration. The position
has a neutral direction orientation. I call this trade the neutral option position.